Revisiting the exchange rate pass through: A general equilibrium perspective

Abstract

A large literature estimates the exchange rate pass-through to prices (ERPT) using reduced-form approaches, whose results are an important input for Central Banks. We show two shortcomings of these empirical measures for monetary policy analysis, which are quantitatively important and may lead to imprecise and biased inflation predictions. First, while the literature describes a single ERPT, which we will label unconditional, there are different ERPT conditional on each shock that hits the economy. Second, these crucially depend on expected monetary policy, so that empirical ERPT measures should not be taken as given in evaluating policy actions. We use a simple model of a small and open economy to understand the intuition behind these two critiques, showing that these results seem to hold under many alternative specifications. We then highlight the quantitative relevance of these distinctions using a large-scale DSGE model of a small open economy.